Economic trends

‘Perfect storm’ piles on woe for Turkey

As geopolitical risks continue to rise in Turkey, its central bank may need to take action to lure investors back

A ‘perfect storm’ of rising risks has dramatically increased uncertainty for investors in Turkey. First, there was the surprise election result in June, followed by weeks of fruitless talks to form a coalition government. Next came the recent terror attacks by the Islamic State group, and now the country is experiencing renewed violent campaigns by Kurdish PKK militants.

As the risks rise, investors continue to move away from Turkish assets, creating huge problems for Turkey’s economy. The country relies on foreign inflows to fund its current account deficit, so the central bank is under pressure to make changes, and fast. It is facing the arduous task of trying to stabilise the Turkish lira, which is currently one of the worst performing emerging market currencies.

If Moody’s downgrades Turkey’s rating, the central bank might have no choice but to raise rates

Adding to Turkey’s woes is the impending decision about its credit rating from ratings agency Moody’s. This Friday, Moody’s will assess whether to maintain the country’s investment grade rating or become the second out of the three main ratings agencies to classify Turkey’s bonds as junk– a scenario that would cause more problems for Turkey’s central bank.

Last week, the central bank tried to buy time by announcing that it would simplify its very complex (and at times confusing) monetary policy framework – something investors, rating agencies and the International Monetary Fund have been requesting for a long time. But as the volatility continues, it might have to hike interest rates to lure foreign investment back into Turkey. In fact, if Moody’s downgrades Turkey’s rating, the central bank might have no choice but to raise rates, in a similar way to January 2014, when the interest rate more than doubled.

Painful

Many clients we spoke to ahead of the June election had adopted an underweight position on Turkey, but were ready to reconsider their level of investment once the political uncertainty had cleared. With uncertainty mounting, many of these investors will feel that they need to be better compensated for Turkey’s current risk profile.

If the talks fail, President Erdogan must call new elections … This would prolong an uncertainty that might become too painful to bear for some short-term investors

The longer talks to form a coalition government continue, the closer it gets to the late August deadline for forming a government. If the talks fail, President Erdogan must call new elections, to be held three months later. This would prolong an uncertainty that might become too painful to bear for some short-term investors. Crucially, new elections could also coincide with the period when the Federal Reserve is expected to raise its rate – adding further pressure to Turkey’s economy.

The positives

There are some positives to Turkey’s economic situation: July figures confirmed that inflation is finally slowing; its current account deficit continues to narrow year-on-year; today’s lower oil prices are favourable; and the country arguably has one of the best fiscal positions among peers with similar credit ratings. But the accumulation of geopolitical risks – both domestic and regional – might lead to an abrupt change in monetary policy that would put a break on the already feeble growth story.

 

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